ACYMANS: FS Analysis

Financial Statement Analysis

Involves the evaluation of an entity's past performance, present condition, and business potentials by way of analyzing the financial statements to obtain information about, among others, profitability of the business firm, ability to meet company obligations, safety of investment in the business, and effectiveness of management in running the firm.

Goal of Accounting

To provide information that allows decision makers to understand and evaluate the results of business decisions. In short, it is to provide information in order to make decisions. Managers analyze financial statements to evaluate financial performance and make future decisions.

Vertical Analysis

Also known as Common Size Financial Statements. It focuses on important relationships between items on the same financial statement. These items are compared vertically, from one account balance against another, and are typically expressed as percentages to reveal the relative contributions made by each financial statement item.

Line Items on the Balance Sheet

Are generally expressed as a percentage of total assets.

Line Items on the Income Statement

Are generally expressed as a percentage of net sales.

Vertical Analysis

Is the process of comparing figures in the FS within a single period. This is accomplished by expressing all figures in the FS as percentages of a common base such as total assets (for the balance sheet) or net sales (for the income statement). These converted statements are called common-size statements or percentage composition FS, often used for comparing multiple years of data from the same firm, companies of different size, and company-to-industry averages.

Horizontal Analysis

It is conducted to help financial statement users recognize important financial changes that unfold over time. It compares information horizontally, from one period to the next, with the general goal of identifying significant sustained changes. These changes are typically described in terms of peso amounts and year-over-year percentages (if in percentages, each item is expressed as a percentage of the base year figure).

Horizontal Analysis

Shows changes of corresponding FS items over a period. Changes in the value of a particular FS item can be analyzed in terms of amount or in percentage. Comparisons can be made between an actual amount and a budgeted amount, with the latter serving as the 'base' or pattern of performance. If a zero or negative amount appears in the base year, percentage change cannot be computed.

Percentage Change

Most Recent Value - Base Period Value/Base Period Value or Current Year - Base Year/Base Year

Trend or Index Analysis

A subset of horizontal analysis, uses an index number of 1.00 for the base period and converts all FS items in the subsequent period as percentage of the base in order to facilitate better understanding of performance over multiple periods.

Cash Flow Analysis

Is a detailed study in the net change in cash and cash equivalents because of operating, investing and financing activities during the period.

Operating Activities

Are principal revenue-producing activities of the entity and generally relate to changes in current assets and current liabilities involved in company's normal operations.

Investing Activities

Are acquisition and disposal of long-term assets and investments not included in cash equivalents and generally relate to changes in a company's non-current assets.

Financing Activities

Are result in changes in the size and composition of the contributed equity and borrowings of the entity and generally relate to changes in long-term liabilities and equity accounts.

Ratio Analysis

An analysis conducted to understand relationships among various items reported in one or more of the financial statements. It shows the evaluation of the company's performance given the level of other company's resources.

True

(True or False) For meaningful analysis, ratios are best compared with both historical and industrial averages.

Limitation of Ratio Analysis

No analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company's financial results. Without interpretation, these computations can appear as nothing more than a list of disconnected numbers.

Financial Ratios

Are relationships among accounts found in the FS that provide information about the firm's liquidity, solvency, stability, profitability and other aspects of financial situation and potential.

Gross Profit Variance Analysis

It has the primary goal of improving performance and profitability in the future. Profit, whether it is gross (if absorption costing) or contribution margin (variable costing), is affected by three basic items:

a. Sales price

b. Sales volume

c. Costs

d. Sales mix (Only in multi-product firm whose products are not equally profitable).

True

(True or False) Contribution margin is considered a better measure of product profitability because it deducts from sales revenue only the variable costs. Gross profit does not reflect CVP relationships.

Liquidity Ratios

Ratios that measure an entity's ability to meet short-term obligations and provide insights on present cash solvency. Common examples include net working capital, current ratio and quick ratio.

Solvency Ratios

Also known as Liquidity Ratios. Are ratios that measure an entity's long-term financial viability. Common examples included debt ratio, debt-equity ratio and times interest earned ratio.

Activity Ratios

Also known as Asset Utilization Ratios or Efficiency Ratios. Are ratios that measure an entity's ability to use its assets and manage its liabilities effectively in the current period -- how quickly various accounts are converted into sales or cash. Common examples include turnover ratios and conversions periods.

Profitability Ratios

Also known as Performance Ratios. Are ratios that are used to determine how well an entity can generate profits from its operations. Common examples include margin ratios and return ratios.

Market Value Ratios

Also known as Market Prospect Ratios. Are ratios that are used to help potential investors make equity investment decisions using trends in earnings, dividends and stock prices. Common examples include dividend payout ratio, dividend yield and price-earnings ratio.

Profitability Ratios

Are ratios that relate to the company's performance in the current period. It shows the company's ability to generate income.

Liquidity Ratios

Are ratios that relate to the company's short-term survival. It shows the company's ability to use current assets and current liabilities as they become due. It measures the short-term ability of the enterprise to pay its obligations and to meet unexpected needs for cash.

Solvency Ratios

Are ratios that relate to the company's long-run survival. It shows the company's ability to repay lenders when debt matures and to make the required interest payments prior to the date of maturity.

Rules in Calculating Financial Ratios

When calculating a ratio using balance sheet (BS) amounts only, the numerator and denominator should be based on amounts as of the same BS date. The same is true for ratios using only income statement (IS) numbers. Exception: calculation of growth ratios.

Rules in Calculating Financial Ratios

If an IS amount and a BS amount are used at the same time to calculate a ratio (e.g., turnover ratios), the BS amount should be expressed as an average for the time period represented by the IS amount.

Rules in Calculating Financial Ratios

If the beginning balance of a BS account is not available and cannot be computed from the given data, the ending balance of the account is used to represent the average balance.

Rules in Calculating Financial Ratios

If sales and/or purchases are given without making distinction as to whether made in cash or on credit, assumptions are made depending on the ratio being calculated:

➢ Turnover ratios: Sales and purchases are made on credit.

➢ Cash flow ratios: Sales and purchases are made in cash.

Rules in Calculating Financial Ratios

As a rule, an operating year is assumed to have 360 days, unless specified otherwise.

➢ A 360-day year is often preferred since it is consistent with a 12-month year and a 30-day month;

➢ Alternatively, a year may be comprised of 365 calendar days, 300 working days or 270 productive days. (NOTE: the number of days to be used is specified in most problems).

Additional Funds Needed

Is determined based on a variety of financial ratios that help calculate an entity's external capital needs:

Required Increase in Assets - Spontaneous Increase in Liabilities - Increase in Retained Earnings

Additional Funds Needed from External Sources (E.g. Creditors and Investors)

Required Increase in Assets - Spontaneous Increase in Liabilities - Increase in Retained Earnings

Additional Funds Needed from External Sources (E.g. Creditors and Investors)

Change in Sales x (Assets/Sales) - Change in Sales x (Liabilities/Sales) - (Earnings After Tax - Dividend Payment)

Additional Funds Needed from External Sources (E.g. Creditors and Investors)

Total Changes in Equity - Internal Financing

Additional Funds Needed from External Sources (E.g. Creditors and Investors)

(Assets - Liabilities)(Change in Sales) - (Projected Sales x Profit Margin x Plowback Ratio)

Net Profit Margin or Return on Sales

Net Income/Net Sales

Net Profit Margin or Return on Sales

Represents the percentage of revenue that ultimately makes it into net income, after deducting expenses. It determines the amount of income by owners.

Return on Total Assets

Net Income/Average Total Assets

Return on Total Assets

It shows the efficiency with which assets are used to operate a business.

Return on Equity (ROE)

Net Income/Average Shareholders' Equity

Return on Equity (ROE)

It compares the amount of net income to average stockholders' equity. It reports the net amount earned during the period as a percentage of each peso contributed by stockholders and retained earnings in the business.

Gross Profit Percentage

Net Sales - COGs/Net Sales

Gross Profit Percentage

Gross Profit/Sales

Gross Profit Percentage

It indicates how much profit was made, on average, on each peso of sales after deducting the cost of goods sold.

Asset Turnover

Net Sales/Average Total Assets

Asset Turnover

It indicates the amount of sales revenue generated for each peso invested in assets during the period.

Operating Profit Margin

Earnings Before Interest and Taxes/Sales

Fixed Asset Turnover

It indicates how much revenue the company generates for each peso invested in fixed assets.

Fixed Asset Turnover

Net Sales/Average Net Fixed Assets

Earnings per Share

Net Income for Common Shareholders/Average Number of Common Shares Outstanding

Earnings per Share

It indicates the amount of earnings generated for each share of outstanding common stock.

Inventory Conversion Period or Age of Inventory

360 Days/Inventory Turnover

Inventory Conversion Period or Age of Inventory

360 Days / COGs/Average Inventory

Receivable Collection Period - Age of Receivables

360 Days / Receivable Turnover

Receivable Collection Period - Age of Receivables

360 Days / Net Credit Sales/Average Receivables

Payable Deferral Period - Age of Payables

360 Days / Payables Turnover

Payable Deferral Period - Age of Payables

360 Days / Net Credit Purchases/Average Finished Goods Inventory

Normal Operating Cycle

Age of Inventory + Age of Receivables

Cash Conversion Cycle

Normal Operating Cycle - Age of Payables

Work-In-Process Turnover

Cost of Goods Manufactured/Average Work in Process Inventory

Raw Materials Turnover

Cost of Materials Used/Average Raw Materials Inventory

Inventory Turnover (For Manufacturers)

Finished Goods Turnover + Work In Process Turnover + Raw Materials Turnover

Price/Earnings Ratio

Stock Market Price/Earnings Per Share

Price/Earnings Ratio

It indicates the number of pesos required to buy Php 1.00 of earnings.

Debt Ratio

Total Liabilities/Total Assets

Equity Ratio

Total Equity/Total Assets

Debt to Equity Ratio

Total Liabilities/Total Equity

Equity Multiplier

1 / Equity Ratio

Times Interest Earned Ratio or Interest Coverage Ratio

Earnings Before Interest and Taxes / Interest Payments

Equity Multiplier or Equity Ratio Reciprocal

Assets / Equity

Return on Equity

Return on Sales x Asset Turnover x Equity Multiplier

Return on Equity

Net Income/Sales x Sales/Average Total Assets x Average Total Assets/Average Total Equity

Dividend Yield

Dividend per Share/Market Price per Share

Dividend Yield

It measures the rate of return in the investor's common stock investments.

Dividend Pay-out

It indicates the proportion of earnings distributed as dividends.

Dividend Pay-out

Common Dividend per Share / Earnings per Share

Dividend Pay-Out

Ordinary Share Dividends / Net Income (Ordinary Shareholders)

Retention or Plowback Ratio

100% - Dividend Payout

Net Working Capital

Current Assets - Current Liabilities

Current Ratio (Working Capital Ratio)

Current Assets/Current Liabilities

Quick Ratio or Acid Test Ratio

Current Assets - Inventory/Current Liabilities

Quick Assets

Are cash items and other current assets that can be quickly converted into cash (cash, receivables, marketable securities).

Current Ratio

It measures the company's ability to pay its current liabilities. It is a measure of adequacy of working capital. It is the primary test of solvency to meet current obligations from current assets.

Quick Ratio or Acid Test Ratio

This ratio is a much more stringent test of short-term liquidity. It measures the number of times that the current liabilities could be paid with the available cash and near-cash assets.

Cash Ratio

Cash + Marketable Securities/Current Liabilities

Cash Ratio

It measures the number of times that the current liabilities could be paid using cash and marketable securities.

Rules on Income Basis

If the intention is to measure operational performance, income is expressed as before interest and tax; alternatively, income before 'after-tax' interest may be used to exclude the effect of capital structure.

Rules on Income Basis

If the intention is to evaluate total managerial effort, income is expressed after interest and tax.

Rules on Income Basis

Expressing income after interest but before tax is now rarely applied in business practice.

Rules on Income Basis

Income should include dividends and interest earned if the said investments are included in asset base.

Rules on Income Basis

If used in the context of "Du Pont" technique, income must be expressed after interests, taxes and preferred stock dividends.

Market Value Ratios or Market Prospect Ratios

Are ratios that are anchored on Earnings per Share, which is also considered a profitability ratio.

Earnings per Share

Net Income - Preferred Dividends / Weighted Average Common Shares Outstanding

Book Value per Share

Common Shareholders' Equity/Number of Common Shares Outstanding

Receivables Turnover

It is the time required to complete one collection cycle from the time receivables are recorded, then collected, to the time new receivables are recorded again.

Average Age of Receivables or Days' Sales Outstanding

Number of Days in a Year/Receivables Turnover

Average Age of Receivables or Days' Sales Outstanding

It indicates the average number of days during which the company must wait before receivables are collected.